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    Measured Reality: What It Takes to Reach a Net Return Goal

    Measured Reality: What It Takes To Reach A Net Return Goal Splash image

    Many an investment strategy has failed because promised returns or performance dreams fail to materialize.

    Why?

    A common theme is that the promised performance is simply unrealistic. Proponents of particular stock strategies will often make statements like this: "The [name your strategy] method of selecting stocks should be able to beat the market by 4% without any increase in risk."

    Whenever you see a statement like this, you should ask this question: Is this a reasonable expectation of what the strategy's actual—net—return will be?

    From Gross to Net

    Beyond the talents required to pick the right investments and to time their purchases and sales, there are three elements that reduce return:

    • Transaction costs,
    • Management fees, and
    • Taxes.

    How much you pay in taxes depends on your tax status and the cost basis of your investments and will vary with the investor.

    Transaction costs and management fees, however, are more consistent among investors and can be generalized for individual investors.

    The two variables of transaction costs are: how often you transact, and how much each transaction costs.

    While there are differences in transaction costs for common stocks based on the number of shares traded or the share price, on average the choice of a full-service broker or a discounter is likely to make the most significant difference.

    Spreads can also add significantly to transaction costs per trade. The spread is the difference between the bid price (the highest price prospective buyers are willing to pay) and the asked price (the lowest price prospective sellers are willing to accept) for the same security at a particular time. The spread on a liquid large-cap stock may be as low as 0.1%, but for less liquid securities it may be 0.3% or higher.

    Trading your own portfolio of stocks rather than investing in a mutual fund can make a difference in transaction costs per trade, since institutional brokerage rates tend to be below even the best discount brokerage rates available to most individual investors.

    On the other hand, this advantage may be offset by other factors. For instance, the institutional manager of a mutual fund may trade the portfolio more often than you would managing your own stock portfolio, so that the higher portfolio turnover rate might offset the lower transaction cost per trade. In addition, large block trading can drive up the price of the shares.

    Portfolio turnover is measured by the percentage of your total portfolio value that is traded over a particular period. For example, an annual portfolio turnover of 25% means that a quarter of the value of your portfolio was traded over the year. A high turnover rate, of 200% for example, indicates that you have turned over twice the value of your portfolio.

    Low portfolio turnover combined with high brokerage costs can be just as big a drag on your portfolio's net return as a high portfolio turnover matched with low transaction costs.

    If you manage your own portfolio, the turnover is controllable, but if it is invested in a mutual fund, portfolio turnover is at the discretion of the mutual fund manager.

    Evaluating Return Expectations

    How can you evaluate a reasonable "net" return expectation?

    One way is to gauge the return you would expect to receive on your stock holdings if you were simply to buy and hold, and then adjust that return for transaction costs, management fees and portfolio turnover.

    Table 1 illustrates the effects of various round-trip transaction costs, management fees and portfolio turnover rates, and indicates the required gross performances for given net performances.

    The first section in Table 1 presents the case of an individual investor using a discount broker, where round-trip transaction costs (including spreads) would typically total about 1.5% of the value of the transaction, although in individual cases they may vary. Since professional portfolio managers are not employed in this situation, management fees are zero.

    The second section presents the case of an individual investor using a typical mutual fund and illustrates how portfolio turnover, transaction costs and management fees affect performance. The first assumption for the mutual fund is that management fees plus expenses total 1% of assets. The transaction cost assumption, including the spread and other institutional trading costs, is 1% for a round-trip transaction. If a fund is investing in smaller stocks where spreads and other trading costs are typically high, this may be a low assumption, while for funds that invest in large stocks traded in liquid markets and in large blocks, this cost is probably high. But the 1% charge is not unreasonable in many cases.

     

    The Performance/Cost Trade-Off

    The two sections of the table illustrate the performance/cost trade-off for an individual investor using these various approaches to investing.

    For example, with a 0% turnover in the discount brokerage case, an investor who wishes to receive an 8% return net of all costs would have to receive a gross return of 8%, since without portfolio turnover, there are no brokerage costs and there are no management fees. However, the same situation in the case of the mutual fund requires a 9.0% gross return to equal an 8% net return due to the management fees and other costs of managing a fund.

    In order to achieve an 8% net return in a mutual fund, the table indicates that if the fund has a 100% turnover—far from unusual in the mutual fund industry—a gross return of 10% is necessary. On the other hand, if you were to do it yourself through a discount broker and you turn over your portfolio at the same 100% rate, a gross return of 9.5% would be required to produce a net return of 8%.

    The table illustrates how difficult it is to beat the market using a trading strategy, particularly in these times of much lower stock returns.

    For example, assume you feel that the market will return 3% this year, but you want to earn a higher return of 5%. If you feel you can accomplish this through a combination of better stock picks and timing that would result in a portfolio turnover rate of 50%, you would have to earn a gross return of 5.8%—almost double the market return—to achieve your net return goal using a discount broker.

    Similarly, if you expected a mutual fund to outperform the market and earn a 5% return when the market is expected to earn only 3%, and the fund typically experienced a portfolio turnover rate of 150%, it would actually have to earn 7.5% gross—a high hurdle given the market's low expected return.

    And one final point: These numbers do not include the impact of taxes, which would push the gross required return even higher.

    A Measured Dose of Reality

    The next time you are thinking about your portfolio management techniques, costs and your return expectations, punch the numbers into the formula to test their realism.

    It is worthwhile to test your portfolio numbers as you build your financial plan—and before you pursue a strategy that will rev up your portfolio turnover.

    From Gross to Net: How to Calculate the Required Gross Return

    Table 1 is only meant to provide illustrations—the combination of brokerage costs, management fees and portfolio turnover rates are infinite.

    A calculation that might be helpful for planning and setting realistic investment goals allows you to substitute any of these variables for values appropriate for your situation. The equation below does just that.

    Formula for Calculating the Required Gross Return:

    Gross Return = (Turnover × Round-Trip Transaction Costs) + Management Fees + Desired Net Return

    As an example, if the turnover of your portfolio is 40% a year and you use a full-service broker with a round-trip brokerage cost of 4.0% and your goal is to achieve a net return of 7%, your required gross investment return would be 8.6%:

    (0.40 × 0.04) + 0 + 0.07 = 0.086 = 8.6%

    If your actual gross return is less than 8.6% before brokerage costs, you will not meet your net realized return of 7%.

    In the case of an aggressive growth mutual fund that had a portfolio turnover of 200%, assumed round-trip transaction costs of 1% and an expense ratio (management fees and other fund expenses) of 1.86%, just keeping pace with a 7% return net to investors would require a gross return of 10.86%:

    (2.00 × 0.01) + 0.0186 + 0.07 = 0.1086 = 10.86%

    Note: Figures should be in decimal form—for example, a portfolio turnover ratio of 25% is 0.25; management fees of 1.2% would be 0.012.